Understanding the Pros and Cons of Knock-Out Options

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Understanding the Pros and Cons of Knock-Out Options

A knock-out option is part of a class of exotic choices known as barrier options, which have more sophisticated properties than basic vanilla options. Barrier options are options that exist or cease to exist when the underlying asset’s price reaches or breaches a pre-defined price level within a certain time frame.

Knock-in options are created when the underlying asset’s price reaches or breaches a certain price level, while knock-out options are destroyed when the asset price reaches or breaches a price level. The primary reason for adopting these options is to reduce the cost of hedging or speculating.

Key Takeaways

  • Knock-out options are a form of barrier option that expire worthless if the price of the underlying asset exceeds or falls below a certain level.
  • There are two kinds of knock-out options: up-and-out barriers and down-and-out barriers.
  • Knock-out options minimize losses but also limiting gains on the upside, as is generally the case.
  • The knock-out mechanism is activated even if the targeted threshold is just momentarily violated, which may be risky in turbulent markets.

Knock-out Options Characteristics

There are two basic types of knock-out options:

  1. Up-and-out: For the underlying asset to be knocked out, the price must go over a certain price threshold.
  2. Down-and-out: The underlying asset’s price must fall below a certain level in order to be knocked out.

Knock-out options may be built using either calls or puts. Knock-out options are over-the-counter (OTC) securities that do not trade on options exchanges and are more typically utilized in currency markets than in equities markets.

In contrast to a standard call or put option, which just specifies the strike price, a knock-out option must specify two prices: the strike price and the knock-out barrier price.

Keep the following two considerations in mind while considering knock-out options:

  • A knock-out option will pay out only if it is in the money and the knock-out barrier price is never reached or broken during the option’s life. In this situation, the knock-out option will function similarly to a conventional call or put option.
  • The option expires as soon as the underlying asset price hits or exceeds the knock-out barrier price, regardless of whether the asset price thereafter trades above or below the barrier. In other words, once an option is knocked out, it’s out for the count and cannot be revived, regardless of the underlying asset’s future price behavior.
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Knock-out Options Examples

(Note: In these cases, we assume that the option is knocked out if the barrier price is breached.)

Example 1 – Up-and-out Equity Option

Consider the case of a $100 stock. A trader pays $2 for a knock-out call option with a strike price of $105 and a knock-out barrier of $110 expiring in three months. Assume a three-month simple vanilla call option with a strike price of $105 costs $3.

What is the trader’s reasoning for purchasing the knock-out call rather than a regular call? While the trader is clearly optimistic on the stock, he/she believes it has limited potential above $105. As a result, the trader is ready to forego some stock gain in exchange for a 33% reduction in option cost (i.e., $2 rather than $3).

If the stock moves over the $110 barrier price during the option’s three-month tenure, it will be knocked out and cease to exist. However, if the stock does not move over $110, the trader’s profit or loss is determined by the stock price around (or at) option expiry.

If the stock is trading below $105 immediately before the option expiry date, the call is out of the money and will expire worthless. If the stock is trading above $105 and below $110 right before option expiry, the call is in-the-money and has a gross profit equal to the stock price minus $105 (the net profit is $2). Thus, if the stock is trading at or around $109.80 at the time of option expiry, the gross profit on the investment is $4.80.

This knock-out call option has the following payment table:


Stock Price at Expiration*

Profit or Loss?

Net P/L Amount

< $105

Loss

Premium paid = ($2)

$105 < Stock price < $110

Profit

Stock price less $105 less $2

>$110

Loss

Premium paid = ($2)

*Assuming barrier price has not been breached

Example 2 – Down-and-Out Forex Option

Assume a Canadian exporter wants to use knock-out put options to hedge US$10 million in export receivables. The exporter is worried about a possible increase of the Canadian currency (which would result in less Canadian dollars when the US dollar receivable is sold), which is now trading at US$ 1 = C$ 1.1000 in the spot market. As a result, the exporter purchases a one-month USD put option with a notional value of US$10 million, a strike price of US$ 1 = C$ 1.0900, and a knock-out barrier of US$ 1 = C$ 1.0800. This knock-out put costs 50 pips, or C$ 50,000.

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In this scenario, the exporter is betting that even if the Canadian dollar increases, it will not rise much over 1.0900. If the US dollar ever trades below the barrier price of C$ 1.0800 during the option’s one-month existence, it will be knocked out and cease to exist. However, if the US dollar does not fall below US$1.0800, the exporter’s profit or loss is determined by the exchange rate just before (or at) option expiry.

Down-and-out option.

Assuming the barrier has not been exceeded, three distinct possibilities emerge at or around the expiry of the option:

(a) The Canadian dollar is now trading between C$ 1.0900 and C$ 1.0800. The gross profit on the option transaction in this scenario is equal to the difference between 1.0900 and the spot rate, with the net profit equal to this amount minus 50 pips.

Assume the spot rate is 1.0810 right before option expiry. Because the put option is in the money, the exporter’s profit is equal to the strike price of 1.0900 minus the spot price (1.0810) less the 50-pip premium paid. This translates to 90 – 50 = 40 pips = $40,000

Here’s how it works. Because the option is in the money, the exporter sells it for US$10 million at the strike price of 1.0900, netting C$10.90 million. By doing so, the exporter avoided selling at the current market rate of 1.0810, which would have resulted in C$10.81 million in revenues. While the knock-out put option generated a gross notional profit of C$90,000, deducting the cost of C$50,000 yields a net profit of C$40,000.

(a) The US dollar is now trading at the strike price of C$ 1.0900. It makes no difference in this situation whether the exporter exercises the put option and sells at the strike price of CAD 1.0900 or sells in the spot market at C$ 1.0900. (In fact, though, exercising the put option may result in the payment of a commission.) The loss is equal to the premium paid: 50 pips, or C$50,000.

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(c) The US dollar is trading above the C$1.0900 strike price. The put option will expire unexercised in this situation, and the exporter will sell the US$10 million in the spot market at the current spot pricing. In this example, the loss is equal to the premium paid: 50 pips, or C$50,000.

Knock-out Options Pros and Cons

The following are the benefits and cons of knock-out options:

Pros
  • Lesser expenditure: The main benefit of knock-out options is that they demand a lower monetary investment than a plain-vanilla option. The lesser initial investment translates into a smaller loss if the option transaction does not work out, and a larger percentage return if it does.

  • Customizable: Because these options are OTC products, they may be tailored to individual needs, as opposed to exchange-traded options, which cannot.

Cons
  • Risk of loss in the case of a substantial move: One significant disadvantage of knock-out options is that the options trader must correctly predict both the direction and amount of the probable move in the underlying asset. While a huge move may result in the option being knocked out and the speculator losing the whole premium paid, it may result in even larger losses for a hedger owing to the termination of the hedge.

  • Not accessible to retail investors: Because knock-out option transactions are OTC products, they may need a particular minimum size, making them unlikely to be available to individual investors.

  • Lack of transparency and liquidity: Like other OTC products, knock-out options may suffer from a lack of transparency and liquidity.

The Bottom Line

Knock-out options are more likely to be used in currency markets than in equities markets. Nonetheless, due of their distinct characteristics, they provide intriguing opportunities for major traders. Knock-out options may also be more valuable to speculators than hedgers, due to the smaller outlay, since the termination of a hedge in the case of a significant move may expose the hedging organization to catastrophic losses.

Investopedia does not provide tax, investment, or financial advice. The material is offered without regard for any individual investor’s investing goals, risk tolerance, or financial circumstances, and may not be appropriate for all investors. Investing entails risk, including the possibility of losing money.

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